Geared to a Main Street audience, this e-newsletter will provide a sampling of the latest speeches, research, podcasts, videos, lesson plans and much more. Sign up now to have this emailed to you monthly at no charge.

The Econ Lowdown e-newsletter is the most convenient way for economics and personal finance teachers to stay up-to-date on the latest videos, podcasts, curriculum, classroom activities and events from the St. Louis Fed.

In-Depth: The Big Banks: Too Complex To Manage?

The phrase “too big to fail” re-entered common use in 2008 after Fannie Mae and Freddie Mac were put into government conservatorship on Sept. 6; the government rescued the large insurance firm AIG starting on Sept. 16; and nine major banks announced on Oct. 14 their intention to subscribe to the Troubled Asset Relief Program (TARP), in which the Treasury would purchase the banks’ preferred stock. More unflattering phrases have become associated with megabanks over the past couple of years.

“Misbehaviors” connected to the big banks magnified the problems already posed by such large, complex financial organizations, which have concerned legislators and regulators for years. Have they successfully created game plans for “too-big-to-fail” firms? Are big banks needed, or do the misbehaviors indicate that such megabanks should not even exist? These and more questions were explored during the Oct. 1 Dialogue with the Fed, part of the St. Louis Fed’s ongoing evening discussion series for the general public.

St. Louis Fed economist William Emmons led the Dialogue, titled “Robo-signing, the London Whale and Libor Rate-Rigging: Are the Largest Banks Too Complex for Their Own Good?” Joining Emmons for the Q&A that followed were Mary Karr, senior vice president and general counsel of the St. Louis Fed; Steven Manzari, senior vice president of the New York Fed’s Complex Financial Institutions unit; and Julie Stackhouse, senior vice president of Banking Supervision and Regulation at the St. Louis Fed. See the videos and Emmons’ presentation slides at www.stlouisfed.org/dialogue-with-the-fed.

Why Were Big Banks Rescued During the Crisis?

The financial crisis reinvigorated the active debate on the “social good” of megabanks—whether they alone can do things smaller financial organizations can’t and whether they truly are more effective and efficient. (See "Economies of Scale and Scope" at the bottom for some details.) The primary point of contention, however, is systemic risk.

Very large and complex banks are considered to have systemic risk because the failure of a megabank would hurt not just the company itself, its creditors and its employees but potentially the entire financial industry and the economy. In other words, they are “too big to fail” without creating dire consequences for the economy.

“Sometimes institutions need to fail. That is essentially what capitalism is about: that when a firm is no longer viable it should be able to leave the market (e.g., fail),” Emmons said. “But we were caught flat-footed in 2008 when the financial system almost collapsed and we had no safe, effective way to wind down failing megabanks.” Consequently, the federal government propped up many large and complex financial institutions—including AIG, Fannie Mae and Freddie Mac—to avoid the damage of chaotic collapses. The lack of a structure to deal with a megabank failure has troubled many policymakers and lawmakers who, as discussed later, are attempting to craft such a mechanism.

Misbehaviors: A Failure of Discipline?

The revelations of recent controversies such as robo-signing, the London Whale and Libor rate-rigging—explored in the “Big Bank Misbehaviors” sidebar at the bottom—as well as other problems not mentioned here indicate that something critical was lacking in the discipline of large, complex banks.

“Discipline” is a combination of an institution’s internal and external governance. Internal governance includes corporate culture, oversight by the bank’s board and managerial self-interest, while external governance comes via supervision and regulation, as well as discipline by product markets, shareholders, depositors, bondholders and counterparties.

Was the internal discipline effective? Not really, Emmons explained: “Some of those misbehaviors point in this direction, that the internal corporate cultures at the largest banks are not an effective mechanism for keeping the banks on the straight and narrow.” As indicated in Figure 1 below, internal discipline generally appears to work well in the best corporations but not as well among the U.S. megabanks, while external governance generally seems to have worked better for megabanks, Emmons said. “The basic message is that there are some real weaknesses on the internal side, and to the extent that we can be effective as supervisors and regulators, we can probably provide fairly effective external sources of discipline,” he said.

Figure 1

Which Forms of Governance Appear To Be Effective for Complex Banks?

Corporate Governance Mechanisms

Internal governance mechanisms

In the best corporations

Among U.S. megabanks

Corporate culture

x

Board oversight

x

Managerial self-interest

x

x

External governance mechanisms

Product-market discipline

x

x

Shareholder discipline

x

x

Depositor/bondholder/counterparty discipline

x

Supervision and regulation

x

Overall effectiveness of governance

xxxxxx

xxxx

“I think it’s also true that board oversight is often lacking,” Emmons said. It’s a perennial issue at small banks and a bigger issue for midsized banks but seems especially challenging for megabanks, as their board members are nonexperts recruited from other economic sectors yet are expected to provide effective oversight of very large and complex organizations. “It’s true that the megabanks operate in very competitive product and labor markets, which pushes them to be more efficient. But the other internal governance weaknesses noted above and their overwhelming complexity appear to make them ‘too big to manage effectively,’” he said.

Both Emmons and Manzari addressed shareholders in response to a question from the Dialogue audience. They noted that small shareholders are exerting some discipline through selling their stock but that there are restrictions on what large shareholders can do and that the type of governing influence that shareholders can have on firms has yet to play out in this changing regulatory environment.

Dealing with Large, Complex Banks

But why didn’t federal regulators catch the misbehaviors and other issues before they became major problems? Complexity. For example, Manzari, responding to a Dialogue audience question, said that supervising a handful of megabanks is definitely more complicated than supervising hundreds or thousands of smaller institutions.

Numerous regulators for one megabank – “Every jurisdiction has some sort of prudential supervisory agencies. A firm that does business in the United States, the U.K., Europe and Asia will have a range of different entities involved in the supervision of that firm. That puts a big premium on communication and collaboration of those different agencies.”

No uniform set of rules across agencies – A nationally chartered bank in the U.S. faces a uniform set of rules, and you don’t have state-to-state differences. However, there is no globally unified regulatory framework for all international firms. “There is an effort to harmonize capital standards (and) liquidity standards, but still you get different rules in different regimes,” Manzari said.

Illustrating Emmons’ prior exposition on megabank discipline, Manzari added that “The very complexity of megabanks often creates relationships inside the firm that become apparent only after the problem manifests itself.”

Addressing supervision of smaller banks, Stackhouse noted that while the supervisory process is easier, there is also a very clear resolution mechanism. Since the financial crisis, more than 400 small banking organizations have failed. “A recent failure in St. Louis hit the papers for exactly one day, and I think it’s pretty much forgotten about because that’s how well (the resolution process) worked,” she said. “We’re not there yet with large institutions.”

How To (Maybe) End “Too Big To Fail”

So, how will we deal with the megabanks? Emmons outlined two basic approaches: radical and incremental. The radical approach involves structural changes imposed on the banks themselves or the creation of a different legal definition of what a bank is and what it can do. Radical proposals include:

Reduce their complexity and size – Revive the 1933 Glass-Steagall Act (partially repealed by the 1999 Gramm-Leach-Bliley Act) prohibiting combining commercial banking with investment banking or insurance underwriting. Also, reduce their size by placing limits on banks’ assets or deposits. However, Emmons said this proposal likely wouldn’t succeed because combining commercial and investment banking was not the main source of problems; in fact, many of the “too-big-to-fail” institutions that caused problems during the crisis would have been allowed to operate under Glass-Steagall.

Create “narrow banks” – Separate payments functions from all other financial activities. Such a bank would take deposits and make payments but not make loans except those that have very little default risk. Emmons said this proposal wouldn’t be successful either because such banks are not likely to be viable. Narrow banks likely would seek to make riskier loans to improve their profitability, while non-narrow banks would seek to enter the payments business in one way or another.

“In fact, we have chosen not to pursue radical approaches to solving the ‘too-big-to-fail’ problem,” he said. “Instead, we’re implementing incremental—albeit significant—reforms of the existing legal, regulatory and governance frameworks in which banks operate.” Meanwhile, bankers, regulators and legislators won’t know whether the regulatory reform efforts will actually work until they are actually used. Those efforts, which have sparked a lot of profound debate throughout the financial industry, include:

Basel III Accord – The third round of the Basel Accords is looking to improve the quality of bank capital and make other changes related to capital so that big banks demonstrate that they “have more skin in the game,” Emmons said.

Emmons also offered another proposal: Make a strictly enforced “death penalty” regime, a law mandating that any bank requiring government assistance would be nationalized, with a plan to sell it back to new shareholders at some point in the future. “The crux of the matter would be carrying through this pledge to re-privatize the institution,” he said. “It should reduce the incentives to take risk because the ‘death penalty’ is such a severe penalty that it would act as a deterrent.” Emmons noted that TARP (the Troubled Asset Relief Program) was a half-step in this direction, in which the federal government took noncontrolling equity positions in megabanks—preferred instead of common equity—and didn’t wipe out shareholders or management.

“It’s not so radical of a proposal because we did impose a ‘death penalty’ on Fannie Mae and Freddie Mac: Their shareholders and management were wiped out. General Motors and Chrysler were forced into bankruptcy, and AIG was effectively nationalized,” he said.

“If this were to be the plan, we would need (to continue the metaphor) an undertaker standing by—an institution that would be ready to exact this discipline on the firms,” he said, pointing to other nations’ permanent “sovereign wealth funds” that can take equity positions in firms.

The Jury Is Still Out

While investigations and lawsuits continue, regulations are written for new laws, and the industry wrestles with proposed capital and other standards, the question remains: Will any of this solve “too big to fail,” successfully rein in systemic risk or prevent future “misbehaviors”? Simply put, we don’t know yet.

“I think it’s really important to realize that these are the early days in terms of the reform efforts for the financial system, and many firms still have to navigate a pretty complex set of changes to the regulatory landscape, how the world is unfolding and how they’re going to generate profits,” Manzari said during the Q&A portion.

Stackhouse noted that of the 400 or so regulations and rules required by the Dodd-Frank Act, only about one-third are actually in place. “The financial community, large banks in particular—those with over $50 billion in assets—have a lot ahead of them,” she said. “The Dodd-Frank Act right now is the mechanism on the table to deal with these very large firms. The jury is still out on how that particular rule making will take place and how effective it will be.”

Big Bank "Misbehaviors"

Although many “misbehaviors” are connected to big banks, the following are three of the most recent ones.

Robo-signing – Inundated with foreclosures when the housing market collapsed, large servicers in judicial states—those that require foreclosures to go through the courts—attested to large numbers of foreclosure affidavits in very short timeframes without fully verifying the information contained in the documents. The federal government and 49 states reached a $25 billion settlement in early 2012 with Bank of America, JPMorgan Chase, Wells Fargo, Citigroup and Ally Financial (formerly GMAC) to resolve the allegations of robo-signing and related matters. More investigations are underway.

The “London Whale” and Hedging – A trader who worked in JPMorgan Chase’s chief investment office in London—dubbed the London Whale—took sizable risks with his trading positions. In its April 13, 2012, earnings release, JPMorgan Chase initially dismissed media reports of its losses from its chief investment office as a “tempest in a teapot.” On May 10, 2012, however, JPMorgan Chase reported that its London CIO office did indeed have derivatives trading losses of around $2 billion—which increased to $5.8 billion (approximately a quarter’s worth of earnings for the bank) by the end of June. The trading losses triggered a congressional hearing and led to the dissolution of the London trading team that incurred the losses. The unit’s chief investment officer also retired in the wake of the losses. As of December 2012, JPMorgan Chase remained under investigation by the SEC and the FBI over how it addressed and disclosed the risks that its chief investment office in London was taking.

Libor “Rate-Rigging” – The London Interbank Offered Rate (Libor) refers to the average interest rate at which major banks are willing to lend to each other. The rate is calculated daily and used worldwide to determine the interest rate charged to creditworthy borrowers for home mortgages, credit cards and other financial instruments. Libor is used as the benchmark in contracts with an estimated total worth of more than $500 trillion worldwide. On July 5, 2012, it was reported that Barclays Bank PLC and pos­sibly other banks manipulated Libor by understating their borrowing costs. Since that time, Barclays’ CEO, chairman and COO have all stepped down and the bank paid $453 million in a settlement with the U.K.’s Financial Services Authority. Recently, the Swiss bank USB reached a $1.5 billion settlement with Swiss, U.K. and U.S. regulators. Investigations into dozens banks are still ongoing.

Economies of Scale and Scope

To help explain why the misbehaviors matter and how they illuminate “too big to fail,” Emmons explored why certain banks became global giants. Given that all banks perform payments and credit, big banks argue that they need to be large and complex because they can better take advantage of economies of scale and scope:

Economies of scale – The average cost per unit of doing one thing declines as the scale of operation increases, such as diversifying default risk in the loan portfolio or paying only the net amount owed on payments clearing and settlement.

Economies of scope – The average costs per unit of doing different things decline as a result of doing them together, such as one-stop financial shopping, banking and insurance; commercial and investment banking; or market-making and trading on a bank’s own accounts.

But does a bank need to be large and complex to succeed? Not necessarily, according to what ongoing St. Louis Fed research suggests. Emmons explained that most scale economies appear to be captured by banks that have between $30 billion and $50 billion in assets, banks that are much smaller than those shown in the first two columns of Figure 2 below.

Figure 2

Size and Complexity of the Seven Largest U.S. Financial Holding Companies

Emmons said the research suggests that big banks’ scope efficiencies may be good for the firms themselves, but not necessarily for the rest of society. Granting that big banks dispute such research as flawed because it doesn’t have enough data from megabanks, Emmons said that the megabanks’ claim that they “passed a market test” during and after the crisis is “simply not true.”

Returns to big-bank shareholders have been poor over time, as bank stocks experienced a 90 percent decline from the beginning of financial crisis, much more than the overall stock market. “There has been some recovery, but they are trailing the market,” Emmons said. “So, whether using 2000 or 2007 as the starting point, bank stocks have vastly underperformed the rest of the market—even with government support.”

Emmons said, “Most, if not all, of the megabanks would have failed without government support during the financial crisis. In other words, in a truly free market, most or all of those banks would have exited.” And large companies are at best lukewarm supporters of big banks, he said.